Don’t Be Fooled By Your Dividend Bias: DRIP Is Inferior To Internal Compounding

Introduction and summary:

Many investors have a strong focus on dividends, so much that I would like to call it an irrational dividend bias. Dividend investors focus only on dividend stocks, and for the most part ignore those stocks which don’t pay a dividend. Thus, they leave out a huge segment of the market that has the potential of compounding faster than dividend stocks (as this article will show you). A company that can reinvest/redeploy retained earnings at acceptable returns, is far more preferable than reinvesting a dividend into the same company. DRIP is simply an extremely inefficient way to compound (in most cases), but this article is not a case against DRIP. Some companies simply generate so much cash that they have to distribute it. As an investor you are well advised to make sure you have an agnostic view on how to compound the most efficiently.

I quote Warren Buffett from Berkshire’s shareholder letter of 2012:

Of course, a shareholder in our dividend-paying scenario could turn around and use his dividends to purchase more shares. But he would take a beating in doing so: He would both incur taxes and also pay a 25% premium to get his dividend reinvested. (Keep remembering, open-market purchases of the stock take place at 125% of book value.)

Over the long-term the earnings, either reinvested or distributed, are the main source on your compounding result. In other words, your initial capital is of less importance compared to how you reinvest the earnings! This article shows the mathematics why DRIP and reinvestment above book values are so detrimental to the future marginal rate of return and long-term compounding.

You might want to read the other articles I have written on the subject of dividend investing before you read this one:

Let’s start by defining the two terms used in the headline:

DRIP

DRIP is an abbreviation for dividend reinvestment plan. This is a program that allows investors to automatically reinvest the dividends into additional shares in the same company. DRIP is most common in the US and the UK.

It works like this: If you receive 200 USD in dividends from Altria (MO), those 200 dollars are automatically converted to additional shares, about 5 shares at today’s prices. This is done without deducting for dividend taxes, which you have to pay out of your additional funds (if you are in a tax position).

Internal vs. external compounding

Internal compounding is when retained earnings are not distributed to shareholders, but reinvested into the existing business (or for example used to pay back debt etc.). External compounding means that retained earnings are returned to shareholders, mostly via dividends, and the burden of compounding is handed over to you. Managements often mouth that paying a dividend is doing something for the shareholder, but it’s precisely the opposite: management simply sees no opportunities for reinvestment, and you as an investor have to get off your ass and spend time reinvesting those same funds.

Dividends have three caveats

The first is taxes. Research shows dividend-paying stocks have outperformed non-payers, but this is before considering taxes on the dividends. Most investors are in a tax position, and this is of course a huge headwind in the real world.

The second is opportunity costs. Could the dividend be better spent reinvested into the existing business?

The third is that it’s far easier to compound by retaining the earnings than distributing via DRIP/reinvestments. The aim of this article is to show this via an example featuring two identical companies:

An example of a dividend payer and one non-payer

This Google sheet provides a mathematical example of the performance of two identical companies: Company A pays out 50% of the earnings as dividends which the investor subsequently DRIP at year’s end, and Company B which retains 100% of earnings. Both companies grow book value/shareholder’s equity at 10% and both trades at two times book value.

When Company A is trading at two times book value, you reinvest the dividend at 5% return on equity (ROE), not 10%, because you “exchange” your equity for 0.5 equity. This means that the CAGR of the share price in Company A gradually gets closer to 5% as time pass. At two times book value the CAGR in Company A is only 7.5% over 20 years. much lower than the 10% in company B. This means Company B is a better investment as long as it manages more than 7.5% return on the retained earnings.

To keep up with Company B, which of course grows at 10% for all of equity (because none is distributed to shareholders), Company A needs to have 20% ROE to generate 10% CAGR over 20 years (2x 10%). If both companies trade at five times book value the ROE in company B needs to be 50% (to keep up with the non-distributed 10% growth in Company B).

The table below summarizes the performance (CAGR) of these two companies with different premiums to book value:

External compounding
Internal compounding
P/B DRIP
No dividends (reinvestment)
Company A Company B
CAGR 20 years: CAGR 20 years:
0.75 11.7% 10%
1 10 10
1.5 8.3 10
2 7.5 10
3 6.7 10
4 6.2 10
5 6.0 10

If a stock trades at a discount to book value, then it obviously makes sense to both pay and reinvest a dividend. Gazprom (OGZPY) currently trades at about 0.5 times the equity which means that after reinvesting you own double the equity than before (you would be receiving a dollar in book value but reinvesting at just half the dollar, thus receiving 2x of the equity). This additionally means that every dollar (or rouble) retained in Gazprom is only transformed to about 50 cents of market value. In the letter of 1984 Buffett called the latter “gold-into-lead-process”, and meant that most earnings should be distributed back to shareholders in such a discount to book scenario.

The table above doesn’t include taxes on the dividend.  If we include a 15% withholding tax we obviously see a further drop in the CAGR for the DRIP methodology:

External compounding
Internal compounding
P/B DRIP
No dividends (reinvestment)
Company A Company B
CAGR 20 years: CAGR 20 years:
0.75 10.7% 10%
1 9.2 10
1.5 8.3 10
2 7.5 10
3 6.7 10
4 6.2 10
5 5.8 10

Conclusion

Given two identical companies, you better choose the one which can reinvest earnings. It’s the most efficient way to compound!

If a company doesn’t pay a dividend you simply sell shares in the company to create “income” (if you somehow need cash), which is the same as receiving a dividend, actually better as long as the stock is trading at a premium to book value (read my previous article on this subject). As I have often mentioned on this blog: why receive at par to equity when you can sell your equity at a premium (assuming the stock trades at a premium to equity, which most stocks do)?

 

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